An Approach to Avoid A federal DEbt Crisis

January 25, 2019

Introduction

The current method of managing the federal budget is not viable and could create or exacerbate a financial crisis down-the-road if left unchecked.

In the last ten years, the federal debt has soared by $10 trillion and now stands at $22 trillion. As a percentage of Gross Domestic Product (GDP), the debt is 105%, or very close to its all-time high. This ratio puts the U.S. in the top five percent of highly leveraged countries with such notables such as Bhutan, Congo and Cape Verde.

And the worst is yet to come. The Congressional Budget Office projects the deficit to grow to over $33 trillion in the next ten years. And this does not reflect the fact that the promised obligations of Social Security and Medicare to retirees are underfunded.

Moreover, interest rates can have a big effect on the deficit levels. The CBO uses an average interest rate of 3.1% over the 10-year period. Historically, this estimate is quite low. For example, it was almost 10% in 1988. For each one percentage point increase in interest rates above the projected level, the annual deficit would increase by more than $200 billion.

Currently, more than $6 trillion in the outstanding debt is held by foreign entities, including over $1 trillion by the People’s Republic of China. As the Bank of International Settlements has stated, a sudden rush to the exits cannot be ruled out.

None of this should come as a surprise. In November 2014, the CBO issued a report analyzing 79 options that lawmakers could take to reduce the annual deficit and national debt. Their options echoed the recommendations of the bipartisan Simpson-Bowles Commission that combined deep cuts in military and domestic spending, reduced or ended popular tax breaks, and significantly changed the entitlement programs of Social Security and Medicare. Their suggestions included revenue increases, as well as spending reductions.

No such meaningful actions were taken. In fact, just the opposite recently occurred in the form of a large tax cut.

The political dynamics in the nation’s capital simply don’t offer much hope for financial discipline. Even if this weren’t the case, the reality is that closing a $1 trillion gap in a $4.3 trillion budget would be virtually impossible to do given the parties’ diametrically opposed platforms on taxes and social programs.

Hence, we can be certain that the federal debt will continue to grow.

A Broader Assessment of the Situation

The Congressional mismanagement of the federal budget is not the complete story of the U.S. economy. Just as the financial fortitude of the federal government has eroded over time, the net worth of U.S. households has soared to $106 trillion. The same effect is true for the market value of U.S. companies, which makes up more than 25% of household’s net worth.

While looking at the “income statements” and “balance sheets” of the federal sector, the private sector and the public, we see:

1) The “income statement” of the federal government will continue to hemorrhage large annual deficits

2) The “balance sheet” of the federal government will continue to show large and growing negative “retained earnings”.

3) The income statement for for-profit organizations is positive, but the incomes and taxes are near levels that are price elastic and therefore don’t provide room for much more tax revenue to be collected from higher taxes.

4) The balance sheet of for-profit organizations is healthy and retained earnings are expected to increase substantially over time.

5) The income statement for households is positive, but it is difficult politically to capture more tax revenue from individual households.

6) The balance sheet for US households is strong. However, upon sale of assets, capital gains are taxed at levels that are difficult to increase from a political perspective.

Looked at in this light, the most viable source of funds that can meaningfully reduce the federal deficit is the balance sheets of for-profit organizations. But how can this be accomplished?

Taking a step back, the preamble of the U.S. Constitution says that the federal government exists to help “form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity.”

The Constitution provides the federal government with the right of taxation and the right of eminent domain to achieve these objectives. The concept of eminent domain allows the federal government to take property in exchange for just compensation. For example, it has been utilized to facilitate transportation, supply water, construct public buildings and aid in defense readiness.

In fulfilling its mandate, the U.S. federal government has done a good job in:

1) providing security to ensure domestic tranquility,

2) adopting policies such as free trade, protection of Intellectual Property, deterrence of anticompetitive behavior, etc. to ensure prosperity and

3) enforcing the rule of law to promote competition and enhance the general welfare of its citizens.

Taken together, the federal government provides an environment that yields substantial value to business organizations – which is currently provided at no direct cost to businesses.

In fact, the enterprise value of US companies is $32 trillion or the equivalent of $153,000 per adult. This compares favorably to other strong economies such as Japan and Germany with values of $6.2 trillion and $ 2.3 trillion, or $68,000 and $43,000 per adult, respectively.

While a large part of this differential can be attributed to American ingenuity and the superior natural resources of the country, certainly the business environment afforded by the federal government is also a major contributing factor.

To put the issue into perspective, if the business environment afforded by the U.S. government were attributed one third of the differential in relative value between these countries, the value to businesses would still be equivalent to roughly to 30% of their market capitalization.

A Stop-Gap Measure to Avoid a Financial Meltdown

As the ratio of federal debt to GDP continues to rise, the risk of default also rises. In a global financial meltdown, the federal government should look at the strongest balance sheet available to it, namely Corporate America, to avoid defaulting. That is, the government could take a non-voting equity stake in for-profit companies as compensation for the services it renders under the Constitutional prerogative of eminent domain.

In particular, the government could require each for-profit organization licensed to do business in the United States to issue to it non-voting stock options (with the strike price set at its current value) equal to 5% of the organization’s outstanding ownership shares.

This percentage dilution is relatively modest compared with the typical 10% to 20% option pool that a company’s executives receive for managing the company.

The stock options would not mature for three years and would expire in ten years if not exercised. In the case of acquisitions, the options would transfer using the acquisition price to determine the number of options to be issued by the acquirer, but the new strike price would continue to be based upon the initial value of the options when granted.

With a rebound from the financial crisis, the market growth rate could average 15% per year over the following 10 years. In this case, the face value of the initial options granted to the US government would then be worth over $5 trillion at the end of that period, and would be well along a path to providing financial sustainability to the federal government’s finances.

While the stock options would not provide cash initially, they would go onto the government’s balance sheet and would stabilize its credit rating and enable alternative financial means to avoid default.

Impact of the Proposed Solution

From a macro-economic perspective, such an approach would pay for itself.

First, this approach would avoid the pain that ultimately comes with excessive debt and subsequent defaults. For example, countries that default on their debt invariably have to devalue their currency and adopt austerity budgets.

Second, there would be no out-of-pocket expenses to businesses when issuing the stock options.

Third, as investors gained confidence in the ability of the government to manage its fiscal house, the overall prices in stock market would increase from the perceived lower risk of default.

Also, the demand for borrowing by the U.S. government over time would be lower, which would yield lower interest rates which, in turn, would yield higher profits and higher stock prices.

In essence, American opportunism and business success would be used to offset the fiscal mismanagement causing the national debt to grow.

Conclusion

With the continued ballooning of the national debt, the federal government should have a plan in place to address a financial crisis that could cascade into a default on the U.S. debt obligations.

The quickest and least disruptive way for the government to stabilize the financial markets and resolve such a crisis would be by taking a 5% “option pool” of all for-profit business organizations licensed to do business in the U.S.

Congress could take this approach proactively before such a collapse or the Executive Branch could take this approach unilaterally in an emergency responding to a financial crisis.

Such a transfer of “property” would represent a fair exchange in value (i.e., just compensation under the doctrine of eminent domain) for the security, legal framework and the competitive marketplace afforded by the federal government to enable businesses to grow and prosper.